Project Financing of Cross-Border Pipelines
Oil and gas reserves closest to traditional markets are being depleted, while new discoveries are being made in more remote locations. In order to link oil and gas markets to reserves, substantial investment in cross-border pipelines will be required over the next several decades.
Even where pipeline development is not strictly necessary in order to enable hydrocarbons to be delivered to market, individual countries and aligned groups of countries, at both ends of the supply and demand chain, are increasingly concerned to diversify their transport options (in order to avoid over-reliance on a single market, transit country or source of energy). For example, one of the reasons why Transneft recently built a Baltic pipeline was to establish a new export port for Russian oil at Primorsk on the Baltic Sea and, thereby, reduce Russian dependence on transit through Latvia, Lithuania, Estonia and Finland.
The very nature of a cross-border pipeline renders its project financing inherently difficult.
A pipeline requires a high level of initial investment and does not generate any revenue to finance debt repayment until the pipeline is completed. For example, the Chad-Cameroon pipeline (a 1,070-kilometer pipeline that transports crude oil from three fields in the Dhola basin in southwestern Chad to a floating facility 11 kilometers off Cameroon) was completed in July 2003 at a cost of $2.2 billion.
Adding to the complexity, most cross-border pipelines involve a number of parties with diverse interests. Cross-border pipelines almost invariably involve both the public and the private sectors. There is an inevitable divergence of interest between these sectors. Within the public sector, the country of production usually wants the highest price for the exported hydrocarbons, the country of transit wants the highest tariff and the country of receipt wants the lowest price and the lowest tariff. A similar divergence of interests arises in the private sector, to the extent that different entities are involved in the supply, transportation and purchase of the relevant hydrocarbons.
However, it has been possible to effect successful project financings in this sector. For example, Chadbourne acted recently for the European Bank for Reconstruction and Development on its financing of the participation by the State Oil Company of the Azerbaijan Republic (SOCAR) in the south Caucasus gas pipeline, which will run from the Shah Deniz gas field off the coast of Azerbaijan, through Azerbaijan and Georgia, before discharging into the Turkish gas distribution system. In addition, the BTC pipeline, which will link the Azeri, Chirag and deep water Gunashli oil fields, off the coast of Azerbaijan with the Port of Ceyhan in Turkey, attracted over $1.5 billion of bank debt, and the Chad-Cameroon pipeline raised $1.4 billion of debt from banks and the capital markets.
Risks and Mitigants
An analysis of risk is fundamental to any decision to provide financing.
When considering whether a risk can be borne, a lender will take account of factors that might serve to mitigate that risk. The lender’s perception of certain risks may depend on what type of institution it is. For example, international financial institutions (like the EBRD and International Finance Corporation) tend to be more comfortable taking political risks from which commercial banks might shy away.
The following is a catalog of key risks that apply in a cross-border pipeline financing followed, in each instance, by examples of how these risks have been successfully mitigated.
Upstream. The establishment of sufficient reserves underpins any successful pipeline project. If a pipeline is being developed to transport existing production, this risk is less important. Greater care will be required in circumstances where a pipeline is being established to transport the production of a specific upstream project. Any analysis of this risk will not simply end with a reserve report showing sufficient development potential. It will also extend to an analysis of the ability of the relevant producer effectively to develop the field and, in the case of offshore reserves, to consideration of delineating national borders to make sure the country purporting to grant the license to develop the field has jurisdiction.
Concerns about the extent of upstream reserves are usually addressed by obtaining a reserve report from a recognized and respected source. For example, the Chad-Cameroon Pipeline was underpinned by proven plus probable reserves of 917 million barrels in the three fields that were to be developed in the Dhola Basin.
Completion. Pipelines are an enormous engineering undertaking involving considerable technical challenges. Until the pipeline is completed, no revenues will be generated to service any project debt.
Ideally, the project should be implemented by means of a construction contract with an experienced contractor on “turnkey” terms that provide for liquidated damages if the contractor fails to deliver. In the case of the BTC pipeline, the Turkish government partially underwrote construction of the Turkish section by guaranteeing its completion under turnkey terms for a fixed price.
Turnkey terms are not often available, and other contractual means to address completion risk will usually have to be sought (for example, express commitments from the project sponsors). In addition, any lender will want to make sure the contractor uses proven technology.
Banks are very unlikely to take completion risk on such complex engineering projects; thus, recourse will be to the balance sheets of the sponsors until completion has occurred.
Operating. Another risk is, even though the pipeline has been successfully completed, it will not operate efficiently or at all. Lenders will want evidence of some guarantee of throughput. Any lender will be anxious to ensure that the length of this commitment extends several years beyond the duration of the scheduled loan repayments and that the amounts generated by shipment at the committed levels will generate enough cash flow to meet scheduled debt service. On the CPC pipeline project (completed in 2000 to link the Tengiz oil field in Kazakhstan with the Russian port of Novorossiysk), the fact that the oil producers refused to sign throughput and deficiency agreements (which would have constituted a commitment to ship a specified level of oil), appears, according to a joint UNDP/World Bank report in June 2003, to have played a part in the initial construction of the pipeline proceeding without bank financing.
For pipelines (especially gas pipelines) that are being developed in conjunction with a specific upstream project, this risk will tend to be less significant, as the pipeline may well constitute the only available means for the export of the reserves of a designated field. There is a tendency for the same commercial parties to be involved at the upstream and the midstream level. For example, ExxonMobil, Chevron and Petronas participated in the same equity proportions to each other in the upstream and midstream project companies responsible for the development of the Dhola Basin oil fields and the construction and operation of the Chad-Cameroon pipeline. The result was there was minimal risk that the upstream parties would choose an alternative export route. In contrast, the participants in the construction of the BTC pipeline were not identical to the participants in the development of the Azeri, Chirag and deepwater Gunashli fields.
Market. Any bank lending money for construction of a pipeline will want to make sure that there is a viable market for the relevant hydrocarbons. If no established market exists, or there is uncertainty about the ability of the market to consume the piped hydrocarbons, then the debt might not be repaid. This issue is of particular concern for a gas pipeline. Gas is much harder to transport than oil; it can only be piped or transported as LNG. For example, in the 1990’s, a large pipeline was constructed across Poland to supply gas from Russia to the German market. It was intended that substantial volumes of the transported gas would also be made available to Poland. However, the Polish market has been able to absorb very little of this gas because Poland relies heavily on local coal to generate electricity. In the context of an oil pipeline, the presence of an immediate market is less significant, as the nature of oil renders it much easier to transport to alternative markets.
It will often be the case with a new cross-border gas project in a less developed gas market that the market will be constituted by a single counterparty. For example, most of the gas piped through the south Caucasus gas pipeline will be sold to BOTAS, the Turkish state gas company, which is then responsible for its wider distribution through the Turkish market. In these circumstances, a bank’s analysis of risk will focus primarily on the counterparty’s creditworthiness and the terms of the contract. However, the viability of the market as a whole will remain a relevant consideration, as, if the designated counterparty can not resell the gas, it is more likely to default. In the Bolivia-Brazil gas pipeline, which was completed in March 1999, potential lenders were very concerned about the ability of the underdeveloped Brazilian gas market to absorb gas that would be piped from Bolivia. As a consequence, Petrobras (Brazil’s state-owned oil and gas monopoly) effectively underwrote performance of the pipeline by contracting to take enough gas to ensure its profitability.
Legal. Any potential lender will want an assurance that all countries through which the pipeline will run have a secure legal framework to facilitate its construction and operation. Lenders will want to know that a viable forum exists for the settling of any disputes. The analysis of both of these issues will be complicated by the fact that cross-border pipelines, by definition, involve multiple legal regimes.
In the south Caucasus gas pipeline, each of the countries through which the pipeline would run (Azerbaijan and Georgia) entered into host government agreements with the project company. These host government agreements override all local laws (other than the constitution) and addressed such key legal issues as the grant of exclusive rights to develop and implement the project, protection from expropriation and the guarantee of the free movement of goods, services, personnel and currency. In addition, each of Azerbaijan and Georgia agreed to submit disputes arising under the host government agreements to international arbitration.
Tax. Local taxes should not impair the ability of the project to service any bank debt. In general terms, lenders prefer a situation where taxes are levied on the profit of the pipeline company, rather than the throughput of the pipeline, as the former can only reduce the amounts available to repay bank financing, while the latter could prevent it. In the south Caucasus gas pipeline, the tax risk was addressed by means of host government agreements granted by each of Azerbaijan and Georgia. Each of these documents set out the tax regime for the project and imposed limited direct taxation which would only apply on profits. In addition, only nominal customs duties were imposed.
Regulatory. A potential lender will want to ensure that there is a viable regulatory regime in each relevant country. The key requirement for the producing country will be the unfettered and absolute grant of relevant permits and licenses to enable development of the field.
With respect to any country of transit, regulatory concerns will relate to pipeline transportation charges and, as a pipeline is a natural monopoly, any regulations designed to promote competition. In certain countries, the regulatory environment is complicated by a requirement that all pipelines operate on a “common carrier” basis with third party rights of access. In other words, pipelines cannot be reserved for the product of specific fields. This is the case in Russia, although this requirement was waived for the CPC pipeline.
Turning to the country of discharge, the focus will be on the regulation of prices. In the context of an oil pipeline, the ability to transport oil relatively easily to an alternative market renders any price regulation of less relevance than would be the case for a gas pipeline.
What constitutes a viable regulatory regime will vary depending on the status of the project. In order to encourage initial investment, the investors need to be given assurances that they will be able to operate the pipeline without undue interference from regulatory bodies for a long enough period to guarantee an appropriate return on their investments. The regulatory risk in the south Caucasus gas pipeline was addressed by the host government agreements, each of which contains an exemption from competition, monopoly and similar legal restraints. In addition, the state authorities were compelled to provide a full list of any required permits and approvals, which they would then be obliged to issue on a priority basis.
The regulatory situation is complicated because the countries through which the pipeline passes usually have different regulatory systems. This concern was addressed in the West African gas pipeline by establishment of a single regulatory regime across all of its countries of operation (Ghana, Togo, Benin and Nigeria).
Political. The political situation can change in a way that is detrimental to development or operation of the pipeline. For example, a radical change in a regime may lead to detrimental changes in state policy. This problem hampered the Iraq Petroleum Company (IPC) pipeline from Kirkuk in Iraq to Banias in Syria. The project was completed in 1952. In 1966, a new extreme wing of the Ba’ath party took over the Syrian government and demanded that the transit fee be renegotiated. The pipeline was shut for several months while this process took place. Further demands for renegotiation led to the pipeline being rendered inactive from 1976 to 1979. Lenders should also consider the risk that the pipeline could be subject to political violence. In 1969, the Tapline crude oil pipeline from the Gulf to the Mediterranean via Jordan, Syria and Lebanon was closed for 112 days following sabotage in the Golan Heights by the Popular Front for the Liberation of Palestine.
An important generic mitigant of political risk is stable governments. However, the nature of the countries where many hydrocarbon deposits are discovered, and through which they must be transported, does not usually allow lenders this luxury. Often, the best mitigant of political risk is naked self-interest. In general, any producing country will be strongly motivated to ensure the success of a pipeline which, in effect, converts its natural resources into cash. Thus, European buyers of Soviet gas in the 1980’s were prepared to lend capital to the USSR for the construction of massive inter-continental gas pipelines. The view was taken that, regardless of the political risk involved in advancing funds to the other side of the “Iron Curtain,” the need of the USSR to sell its gas would ensure the successful performance of the pipeline.
The situation with transit countries can be more complex. The benefits on offer to any transit country must be sufficiently enticing to prevent it from interfering with transit. Georgia, as the transit country for the south Caucasus gas pipeline, has been rewarded by the ability to take gas at greatly reduced prices. Georgia is currently troubled by electricity outages due to a lack of money to pay for gas. Georgia also signed an inter-governmental agreement with Azerbaijan that confirmed its commitment to uninterrupted transit.
Another mitigant can be involvement of a local partner. A domestic partner who stands to benefit from the successful operation of the project might use its political clout when the government tries to alter tax and royalty structures. For example, in both the BTC pipeline and the south Caucasus gas pipeline, the lenders took comfort from the fact that SOCAR would be a participant in both the upstream and the midstream projects. However, the involvement of a local partner can weaken the quality of any completion guarantee provided by the project sponsors. Furthermore, in both pipelines, comfort was obtained from the direct commitments provided by Azerbaijan and Georgia in the host government agreements.
As a measure of last resort, pipelines have been routed to avoid political risks that cannot be addressed by other means. For example, a bypass was added to the northern route export pipeline, which is being used to transport oil from the first stage of the development of the Azeri, Chirag and deepwater Gunashli fields to Novorossiysk on the Black Sea coast of Russia, in order to avoid Chechnya. In addition, it was decided to route the BTC pipeline and south Caucasus gas pipeline to avoid Armenia.
Conflict. Pipeline projects involve numerous and diverse entities in both the public and private sectors. In a worst case scenario, if a conflict cannot be resolved, a key party could simply refuse to participate further. While the replacement of a private sector participant may be possible, if one of the states involved in the project decides that it no longer wishes to participate, the pipeline will be rendered impotent. For example, Syria closed down the IPC pipeline in 1982 when Iran agreed to supply it with oil instead of Iraq. Lenders will want evidence that all of the parties are motivated enough to ensure success throughout the period of scheduled repayment of the loan.
The best mitigant of the risk of conflict is the creation of as many factors as possible that bind all of the key parties to a successful conclusion for the project. These factors can be both inherent and contractual. For example, in the CPC pipeline, Russia, Kazakhstan and the commercial participants were all inherently interested in the success of the project. However, this unity of interest was further strengthened by the division of the equity interests in the pipeline company itself, which, apart from providing shares for the commercial participants, gave 24% and 19% of the shares to Russia and Kazakhstan, respectively. In the south Caucasus gas pipeline and the Chad-Cameroon pipeline, the risk of conflict between the commercial parties at the upstream and the midstream level was mitigated by the fact that the commercial participants are identical at each level.
The respective needs of the states involved can encourage compliance with their respective obligations. In the south Caucasus gas pipeline, the planned restructuring of the Azeri economy depends on the successful export of its oil and gas reserves. Georgia will greatly benefit from the cheap gas that the pipeline will produce. Turkey has a large and developing gas market. The natural unity of interest that these economic factors creates is strengthened by the intergovernmental agreements under which Turkey and Georgia separately agreed with Azerbaijan to take the steps necessary to implement the pipeline. In the Chad-Cameroon pipeline, Chad and Cameroon expect to generate income of $2 billion and $500 million, respectively, during the 25-year life of the project. In addition, the project employed more than 13,000 local people and presented more than $740 million in procurement to local contractors in such activities as construction, truck transportation, civil works, vehicle maintenance and catering.
The risk of conflict will be reduced if the initial contractual framework is reasonable and allows for a degree of flexibility for changed circumstances. A major reason for the poor performance of the IPC pipeline was the failure of Syria to negotiate favorable terms when the pipeline was established and the fact that legitimate means did not exist to reopen the commercial terms. As a result, the Syrian government constantly closed the pipeline in order to force renegotiation of its transit fees. In contrast, there is a tendency for the more successful cross-border pipeline projects to link the rewards given to the participants to market indices.
Beyond Risk Analysis
It is increasingly the case that a simple analysis of risk is not enough, on its own, to decide whether to invest or provide financing. The general impact of the pipeline on the environment, society and economy must also be considered.
In this area, the multilateral financial institutions lead the way. However, even commercial banks no longer operate in a vacuum where financial return is the sole factor in the decision to lend. They are subject to scrutiny from non-governmental organizations and the media, and the concept of corporate citizenship has become a central facet of business credibility. Thus, the tendency is for the standards imposed by the multilaterals to be adopted by the commercial banks. This is best illustrated by the adoption in 2003 of the “Equator principles” by commercial banks representing more than 80% of the project loan market, under which they agreed to abide by the environmental standards of the World Bank for projects costing more than $50 million. The export credit agencies, which, as agencies of governments, are subject to great public scrutiny, are also becoming increasingly sensitive to these issues.
The involvement of the World Bank and International Finance Corporation in the Chad-Cameroon Pipeline was predicated on provision of sustainable long-term development to both countries. In Chad, the situation was of particular concern due to its record of political instability and widespread corruption. The World Bank addressed these concerns by insisting on establishment of a revenue management program to support direct economic and social benefits for the poor. To this end, all government revenues will be deposited in a dedicated offshore escrow account from which their application will be audited by an independent oversight committee. This nine-member body has been drawn from local civil society, religious organizations, women’s groups and the parliament. It has been charged with ensuring that, after 10% of the funds in the escrow account have been channeled into a future generations fund, the remaining funds are allocated as follows: 80% to education, health, social services, rural development, infrastructure and water management, 15% to the Chad treasury and 5% for regional development in the area of the Doba oil field itself. The committee is being advised and monitored by the World Bank and the US Treasury. To ensure transparency, its reports are disclosed publicly. In addition, environmental concerns were addressed by the establishment of two new large national parks in Cameroon, to compensate for the loss of forest caused by construction of the pipeline.
The Chad-Cameroon pipeline is probably the best illustration of the current trend towards a more holistic approach to pipeline financing. However, the themes of sustainability and transparency that it illustrates will be relevant to any future cross-border pipeline financing in developing economies. Thus, for example, the participants in the BTC pipeline instigated environmental and social impact assessments in each of Azerbaijan, Georgia and Turkey. Their preparation involved in-depth discussions with local landowners and communities. A community investment program was implemented to effect infrastructure improvements such as improved roads, new school equipment and clean water supply. (Steps were also taken to ensure that not a single household was displaced by the pipeline, even to the extent of tunneling underneath a village that could not be bypassed.) In addition, to increase transparency, the governments of Georgia and Azerbaijan have agreed to publish full details of the revenues derived from the pipelines.